RiskWise Property Review – Hotspots DO NOT WORK – The Most Effective Property Investment Strategy Is Risk-Return Approach

There is currently a lot of uncertainty and conflicting messages regarding the Australian property market.

On one hand, there are significant affordability issues, particularly in Sydney and Melbourne that provide housing for about 43% of the Australian population. These affordability issues are a major concern for both the Federal and the State Government, with the new Premier of NSW declares housing affordability ‘the biggest issue’

How come we have simultaneously affordability issues and prices that are out of control, together with a potential oversupply and people who have seen the values of their properties plummeting?

And more importantly, what we need to do now in order to minimize the risk

Risk-Return Investment Approach

In order to understand the meaning of these messages, why some investors have done so well and others lost hundreds of thousands of dollars, and especially, how to improve our investment strategy, we need to better understand the risk-return approach for investment.

We all know what the meaning of a ‘return’ is and how to measure it. In the property market it is the aggregation of the capital growth rate (e.g. 6% of annual capital growth) and the rental return (e.g. the gross rental return is 3.8%) generated by a specific property.

The risk, however, is mentioned by far less frequently and it is significantly harder to measure.

The risks in the property investment segment are equity risk and cash flow risk.

Equity risk is the risk that the value of the property will be decreased or will not deliver a minimum level of required return (e.g. 3% a year), resulting in a poor return. Another aspect of the equity risk is that there might be little demand for a property and it will be very difficult to sell it without absorbing a loss (i.e. while overall the property market is relatively solid, there is only little demand for a specific property).

Cash flow risk is the risk that the rental return will be lower than expected and that the investor will be required, on a regular basis, to cover a significant shortfall between the rental income and the ongoing costs associated with this property.

Both equity risk and cash flow risk should be measured based on the likelihood and the impact of each relevant risk factor, e.g. macroeconomic, government regulation and intervention, international markets, local factors, property type, etc. For example, in Inner-Brisbane there is a significant over supply of units. It is highly likely that the prices will go down. The impact is the reduction rate, e.g. 15% is effectively negative equity to all investors who had a deposit of 10% of the property value.

In any type of investment we expect to see a clear correlation between the risks and the returns:

low risks, such as term deposit accounts with our major banks deliver low return (e.g. 2.5% a year). The risk that the bank will not deliver the expected return is extremely low.

There is a higher risk in Australian shares and a higher level of risk in early stage technology companies (i.e. start-ups). However, the investors in those types of investments classes are aware of the risks and expect very strong return (e.g. typically investors in a start-up company want to see 10 times return on their investment, but they could lose their entire investment in the company)

Why the ‘HotSpots’ approach does not work

The same approach should have been applied to the property market, but it hasn’t. Largely, the property industry is obsessed with the next ‘hot spots’, ‘potential outstanding returns’, ‘top 10 capital growth suburbs’, without taking into consideration the risks and returns associated with each investment. Effectively, this is a return-only based approach.

As a result, we have found that hotspot predictions in Australia underperform the market:

Recent research by RiskWise Property Review on hotspot predictions and their 5 year results, suggests that only 35% of 2011 Property HotSpots and 43% of 2012, performed as well as the research benchmark and significantly lower than the predictions.

Even in NSW, the best performing state, only 51% and 57% of 2011 and 2012 hotspots actually achieved returns in line with the benchmark and

How to apply risk-based approach in the property market

Based on RiskWise Property Review analysis of dozens of data and information sources, it has been proven that houses in Sydney and Melbourne carry a low level of equity risk and deliver, consistently, a high level of return. On the contrary, areas that carry a higher level of risk have delivered very poor returns and were proven to be by far more vulnerable to macro and micro economic impacts.

This means, that there is a distortion is the Australian property market. We can find investments that carry relatively low risk and deliver, in the medium and long term solid return. All we need to do is to buy in the right place, a property that is in a high demand and to hold it for a period of at least 7-10 years.

To demonstrate our point we have analyzed the key characteristics of 5 cities across the world, all of them enjoy a very strong property market, that carry relatively low risk, particularly in the medium and long term.

Our first step is to analyse the city that carries a low risk and deliver a solid return. This must be done before thinking about a specific area in the city, suburb, a specific property development. etc.,

The characteristics of a low risk and solid return city are:

‘The place to be’ – people truly want to live there, regardless to their income. There are plenty of opportunities and options there: culture, restaurants, business, schools

High income earners – one or two dominant lucrative high paid industries, such as financial services and information technology

Strong equity / ‘old money’ – in these areas we also see ‘family money’, ‘old money’

Cosmopolitan city – migration as well as foreign workers in lucrative industries

Poor supply of housing – lack of available land and / poor planning with ineffective / insufficient government intervention

Strong investors activity and effectively a class system – unaffordable housing, effectively two classes of landlords and tenants that, largely, have very little chance to buy the property that they rent in the foreseeable future

How these cities have both low risk and strong return?

Let’s start with the risk, first. With limited supply and when property owners have strong equity and high income, it is highly unlikely that they will be forced to sell, even if the market is a bit weak. There need to be a very significant economic issues, such as a recession, to ‘force’ such buyers to sell.

Now to the return – these cities have all the required fundamentals to enjoy a very strong demand, and more and more people want to live in these areas. Migrates, particularly, have strong preference to such cities.

In a case where the ‘top city’, e.g. Sydney, is too expensive, we need to try and find a city that has as many as the characteristics above, and in Australia, that city is Melbourne. Besides of a potential oversupply of units, Melbourne meets the ‘low-risk’ criteria for houses. We will use Melbourne as an example to demonstrate our investment strategy.

Step two – find an area with low risk and projected solid return

Our next step is to decide which area / suburb we want to invest in. Generally, these are suburbs that either in fully established areas or suburbs in a relatively good proximity to the CBD that enjoy or expect to enjoy a gentrification process.
As an example we can take the inner-West in Melbourne that demonstrates a very similar pattern to the one that we saw in the inner-west of Sydney.

Melbourne Inner-West is projected to follow the success of the Inner-Western suburbs of Sydney.

Currently Melbourne’s Inner-West is outperforming Melbourne’s Inner-East. A similar trend to Sydney Inner-West from 2011 to 2016.

Step three – invest in the right property

Finally, after finding the preferred area to invest, we need to choose the specific property that carries the lower risk and is projected to deliver a solid return.

Factors to consider in when assessing a specific property:

Property type: House/Semi/Townhouse/Unit
Generally there is a preference for houses over units to deliver a solid capital growth. However, the risk associated with a unit or other property types depends on the specific suburb, which is why it should be assessed on a case-by-case basis.

High rise vs small unit blocks
High rise buildings normally carry a higher risk than small unit blocks from both a capital growth and cash flow perspective. The risk that is associated with a high rise building depends on the specific suburb and other factors such as strata payment and specific property features, all of which should be assessed on a case-by-case basis.

Off the plan vs existing properties
There is the possibility that the value of an off-the-plan property may decrease between the original contract date and settlement. This will result in a capital loss, as the equity in the home could be reduced. The risk is further increased if a pre-settlement valuation for a mortgage loan is less than the original value, as there could be a shortfall in funds to complete the sale. If these funds are unavailable, the buyer might lose the deposit paid for the property. An off the plan property also carries a cash flow risk as the actual rental may not meet the expectations.

Expensive or premium properties
Expensive property price that is significantly higher than the median price for similar properties. This increases the risk of limited demand for this type of property as it only appeals to a smaller number of buyers. It also has a potential impact on the gross rental return. Higher weekly rent levels reduce rental demand for this property as well, resulting in longer vacancy periods and/or rental discounting.

Property configuration – number of bedrooms, bathrooms and parking
In various areas, there are different configurations of properties that are desired by buyers and for investment properties, by tenants. A property which doesn’t have the desired configuration (of bedrooms, bathrooms, parking) carries an increased risk of lower demand from home buyers and investors during normal market conditions.